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B. INCOME FROM ANY SOURCE WHATEVER
1. BAD DEBT RECOVERY (See Section 50, RR-2 below.)
2. FORGIVENESS OF INDEBTEDNESS
RR-2, Section 50. Forgiveness of indebtedness –
The cancellation and forgiveness of indebtedness may amount to a
payment of income, to a gift, or a capital transaction, dependent
upon the circumstances.
For example, an individual performs services for a creditor, who, in
consideration thereof, cancels the debt, income to that amount is
realized by the debtor as compensation for his service. If, however, a
creditor merely desires to benefit a debtor without any
consideration thereof cancels the debt, the amount of the debt is a
gift from the creditor to the debtor and need not be included in the
latter’s gross income. If a corporation to which a stockholder
indebted forgives the debt, the transaction has the effect of the
payment of the dividend.
3. TAX REFUNDS - for income tax purposes, as a general rule, tax
refunds are taxable except: Philippine income tax (except fringe
benefit tax); estate or donor’s tax; special assessments; income paid
to a foreign country, if the taxpayer claimed a credit for such tax in
the year it was paid; and stock transaction tax.
RMC. No. 13-80
REFUNDS/TAX CREDITS UNDER SECTION 295 OF THE TAX
CODE—
Taxes previously claimed and allowed as deductions, but
subsequently refunded or granted as tax credit pursuant to Section
295 of the Tax Code, should be declared as part of the gross income
of the taxpayer in the year of receipt of the refund or tax credit.
However, the following taxes, when refunded or credited, are not
declarable for income tax purposes inasmuch as they are not
allowable as deductions:
a. Income tax imposed in Title III of the Tax Code;
b. Income, war-profit and excess profits taxes imposed by
authority of a foreign country; but this deduction shall be
allowed in the case of a taxpayer who does not signify in his
return his desire to have to any extent the benefits of
paragraph (3) of this subsection (relating to credit for taxes of
foreign countries);
c. Estate and gift taxes;
d. Taxes assessed against local benefits of a kind tending to
increase the value of the property assessed;
e. Stock transaction tax;
f. Energy tax; and
g. Taxes which are not allowable as deductions under the law.
SPECIAL TAX CREDITS GRANTED UNDER R.A. 6135 and P.D. 535
— these tax credits and their tax consequences are as follows:
a. Sales, compensating and specific taxes are paid on supplies and
raw materials imported by a registered export producer. Said taxes
are given as tax credit to be used in the payment of taxes, duties,
charges and fees due to the national government in connection with
its operations. (Sec. 7(a), R.A. No. 6135)
The tax credits granted should form part of the gross income to the
enterprise in the year of receipt of tax credit as said taxes paid are
considered allowable deductions for income taxes purposes.
b. In some cases, a registered BOI and tourism enterprise assumes
payment of taxes withheld and due from the foreign lender-remittee
on interest payments on foreign loans. In such cases, the enterprise
is given a tax credit for taxes withheld subject to certain conditions.
(Sec. 7(f), R.A. No. 5186; Sec. 8(c), P.D. No. 535)
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Said taxes assumed by the registered enterprise represent
necessary and ordinary expenses incurred by the enterprise; hence,
deductible from its gross income. Therefore, the tax credits granted
necessarily constitute taxable income of the enterprise.
4. DAMAGE RECOVERY - compensatory damages, as constituting
returns of capital, are not taxable. Thus, amounts received as moral
damages for personal actions, such as alienation of affections, libel,
slander or breach of promise to marry, are not taxable.
5. PRIZES AND WINNINGS –
SECTION 32 (B)(7), NIRC
(c) Prizes and Awards. – Prizes and awards made primarily in
recognition of religious, charitable, scientific, educational, artistic,
literary, or civic achievement but only if:
(i) The recipient was selected without any action on his part to
enter the contest or proceeding; and
(ii) The recipient is not required to render substantial future
services as a condition to receiving the prize or award.
(d) Prizes and Awards in Sports Competition. – All prizes and
awards granted to athletes in local and international sports
competitions and tournaments whether held in the Philippines or
abroad and sanctioned by their national sports associations.
GENERAL RULE: Prizes and Winnings are generally taxable. Such
payments constitute gains derived from labor.
EXCEPTIONS: Not taxable
1. If recipient selected without any action on his part to enter the
contest or proceedings; and the recipient is not required to render
substantial future services as a condition for receiving the prize or
award.
2. Those granted to athletes in local and international sports
competitions and tournaments whether held in the Philippines or
abroad and sanctioned by their national sports associations shall be
exempt from income tax.
3. Prizes and awards in the nature of gifts are not taxable.
6. INCOME FROM ANY SOURCE WHATEVER
(income from illegal sources are taxable)
GUTIERREZ V. COLLECTOR, 101 PHIL 743
Doctrine: The compensation or income derived from the
expropriation of property located in the Philippines is an income
from sources within the Philippines and subject to the taxing
jurisdiction of the place.
Facts:
Blas Gutierrez and Maria Morales was the registered owner of an
agricultural land located in Mabalacat Pampanga. The Republic of
the Philippines, at the request of the U.S. Government and pursuant
to the terms of the Military Bases Agreement of March 14, 1947,
instituted condemnation proceedings in the Court of the First
Instance of Pampanga, docketed, as Civil Case No. 148, for the
purpose of expropriating the lands for the expansion of the Clark
Field Air Base, which project is necessary for the mutual protection
and defense of the Philippines and the United States.
At the commencement of the action, the Republic of the Philippines,
therein plaintiff deposited with the Clerk of the Court of First
Instance of Pampanga the sum which was provisionally fixed as the
value of the lands sought to be expropriated. After due hearing, the
Court of First Instance of Pampanga rendered decision wherein it
fixed as just compensation which values were based on the reports
of the Commission on Appraisal whose members were chosen by
both parties and by the Court. In order to avoid further litigation
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expenses and delay inherent to an appeal, the parties entered into a
compromise agreement modifying in part the decision rendered by
the Court in the sense of fixing the compensation for all the lands,
without distinction, which compromise agreement was approved by
the Court.
The Collector of Internal Revenue demanded of the petitioners the
payment as alleged deficiency income tax for the year inclusive of
surcharges and penalties and included the amount paid by the
Republic in assessing taxes on Morales’ gross income. The counsel
for petitioner sent a letter to the Collector of Internal Revenue
arguing that due compensation from property expropriated was not
"income derived from sale, dealing or disposition of property"
referred to by section 29 of the Tax Code and therefore not taxable.
Section 29 is clear that gross income includes gains, profits, and
income derived from salaries, wages, or compensation for personal
service of whatever kind and in whatever form paid, or from
professions, vocations, trades, businesses, commerce, sales or
dealings in property, whether real or personal, growing out of
ownership or use of or interest in such property; also from
interests, rents, dividends, securities, or the transactions of any
business carried on for gain or profit, or gains, profits, and income
derived from any source whatsoever.
Moreover, section 37 speaks of income from sources within the
Philippines which states that the following items of gross income
shall be treated as gross income from sources within the
Philippines:

This request was denied by the Collector of Internal Revenue,
contending that section 29 is intended to be broad enough in its
construction to subsume “income from any source” as taxable.
Issue:
Whether or not compensation from expropriation is taxable as part
of gross income – YES
(5) SALE OF REAL PROPERTY. — Gains, profits, and income from
the sale of real property located in the Philippines;
These words disclose a legislative policy to include all income not
expressly exempted within the class of taxable income under our
laws, irrespective of the voluntary or involuntary action of the
taxpayer in producing the gains.

Ruling:
The acquisition by government of private property through
expropriation proceedings, said property being justly compensated,
is embraced within the meaning of the term “sale” or “disposition of
property,” and the proceeds of the transaction clearly fall within the
definition of gross income laid down by Section 29 of the Tax Code
of the Philippines.

There is no question that the property expropriated being located in

the Philippines, compensation or income derived therefrom
ordinarily has to be considered as income from sources within the
Philippines and subject to the taxing jurisdiction of the Philippines.
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C. TRANSFER PRICING REGULATIONS
SECTION 50, NIRC. Allocation of Income and Deductions. – In the
case of two or more organizations, trades or businesses (whether or
not incorporated and whether or not organized in the Philippines)
owned or controlled directly or indirectly by the same interests, the
Commissioner is authorized to distribute, apportion or allocate
gross income or deductions between or among such organization,
trade or business, if he determines that such distribution,
apportionment or allocation is necessary in order to prevent
evasion of taxes or clearly to reflect the income of any such
organizations, trades or businesses.
When two or more organizations, trades or business are owned
and controlled directly or indirectly by the same interests, the
CIR can distribute, apportion or allocate the gross income or
deductions between or among such organizations, trades or
businesses, in order to prevent tax evasion.
RR 2-2013
SECTION 5. ARM’S LENGTH PRINCIPLE. – The Bureau of Internal
Revenue (the “Bureau”) hereby adopts and the use of arm’s length
principle as the most appropriate standard to determine transfer
prices of related parties.
a. Background and Concept:
The arm’s length principle is the internationally recognized
standard for transfer pricing between associated enterprises.
Paragraph 1 of Article 9 of Philippine tax treaties is virtually
identical to paragraph 1 of Article 9 of the OECD Model Tax
Convention on Income and Capital, which is considered, in the
international arena, as the authoritative statement of the arm’s
length principle.
Paragraph 2 of Article 7 (Business Profits) of the OECD Model Tax
Convention on Income and on Capital specifies that, when
attributing the profits to a permanent establishment, the permanent
establishment should be considered as „a distinct and separate
enterprise engaged in the same or similar activities and under the
same or similar conditions‟. This corresponds with the application
of the arm’s length principle specified in paragraph 1 of Article 9
(Associated Enterprises) of the OECD Model Tax Convention on
Income and on Capital.
The arm’s length principle requires the transaction with a related
party to be made under comparable conditions and circumstances
as a transaction with an independent party. It is founded on the
premise that where market forces drive the terms and conditions
agreed in an independent party transaction, the pricing of the
transaction would reflect the true economic value of the
contributions made by each entity in that transaction. Essentially,
this means that if two associated enterprises derive profits at levels
above or below the comparable market level solely by reason of the
special relationship between them, the profits will be deemed as
non-arm’s length. In such a case, tax authorities that adopt the arm’s
length principle can make the necessary adjustments to the taxable
profits of the related parties in their jurisdictions so as to reflect the
true value that would otherwise be derived on an arm’s length basis.
b. Guidance on the Application of the Arm’s Length Principle:
The application of arm’s length principle would, first and foremost,
involve the identification of comparable situation(s) or
transaction(s) undertaken by independent parties against which the
associated enterprise transaction or margin is to be benchmarked.
This step is commonly known as “comparability analysis”. It entails
an analysis of the similarities and differences in the conditions and
characteristics that are found in the associated enterprise
transaction with those in an independent party transaction. Once
the impact of these similarities or differences have on the transfer
price have been determined, the arm’s length price/margin (or a
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range) can then be established using an appropriate transfer pricing
method.
In the application of the arm’s length principle the following 3-step
approach, discussed in detail in Sections 6, 7, and 8 of these
Regulations, may be observed.
Step 1: Conduct a comparability analysis.
Step 2: Identify the tested party and the appropriate transfer
pricing method.
Step 3: Determine the arm’s length results.
These steps should be applied in line with the key objective of
transfer pricing analysis to present a logical and persuasive basis to
demonstrate that transfer prices set between associated enterprises
conform to the arm’s length principle.
SECTION 6. COMPARABILITY ANALYSIS. (Step 1)
a. The Concept of Comparability
The arm’s length principle is based on a comparison of the prices or
margins adopted or obtained by related parties with those adopted
or obtained by independent parties engaged in similar transactions.
For such price or margin comparisons to be meaningful, all
economically relevant characteristics of the situations being
compared should be sufficiently similar so that:
(1) none of the differences (if any) between the situations being
compared can materially affect the price or margin being compared,
or
(2) reasonably accurate adjustments can be made to eliminate the
effect of any such differences.
b. Factors Affecting Comparability
A comparability analysis should examine the comparability of the
transactions in 3 aspects:
(1) Characteristics of Goods, Services or Intangible Properties
(i) The specific characteristics of goods, services or intangible
properties play a significant part in determining their values in
the open market. For instance, a product with better quality and
more features would, ceteris paribus, fetch a higher selling
price. Such product or service differentiation affects the price or
value of the product or service. Hence, the nature and features
of the goods, intangible properties or services transacted
between related parties and those between independent parties
must be examined carefully. The similarities and differences
(which would influence the value of the goods, services or
intangible properties) should be identified.
(ii) Characteristics to be examined include, but are not limited
to, the following:
- in the case of transfer of goods: the physical features, the
quality and reliability, and the availability and volume of supply
of the goods;
- in the case of provision of services: the nature and extent of
the services; and
- in the case of intangible property: the form of transaction, the
type of intangible, the duration and degree of protection, and
the anticipated benefits from the use of the property.
(iii) Similarities in the actual characteristics of the product,
intangible or service, are most critical when one needs to
compare prices of related party transactions against
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independent ones, such as when the Comparable Uncontrolled
Pricing (CUP) method is adopted as the transfer pricing method.
On the other hand, comparisons of profit margins (used in
methods other than CUP) may be less sensitive to the features
and characteristics of the product or service in question, as the
margins generally correlate more significantly with the
functions performed, risks borne and assets used by the entity.
(2) Analysis of Functions, Risks and Assets
(i) Economic theory purports that the level of return derived by
an entity should be directly correlated to the functions
performed, the assets used and risks assumed. For instance, an
entity selling a product with warranty should earn a higher
return compared to another entity selling the same product
without the provision of warranty. The difference in margin is
due to the additional function performed and risk borne by the
first entity. Likewise, a product with a reputable branding is
expected to fetch a higher return compared to that of a similar
product without the branding, due to the additional asset (in
this case, trademark) employed in enhancing the value of the
product.
(3) Commercial and Economic Circumstances
(ii) Hence, a crucial step in comparability analysis must entail a
comparison of the economically significant functions
performed, risks assumed and assets employed by the related
party with those by the independent party (which has been
selected as the party against which the associated enterprise’s
margin or transactions are to be benchmarked). This is typically
known as conducting a “functional analysis”.
(iii) The functions that should be compared include (but are not
limited to) design, research and development, manufacturing,
distribution, sales, marketing, logistics, advertising, financing,
etc.
(iv) It is also relevant and useful, when identifying and
comparing the functions performed, to consider the assets that
are employed or to be employed. This analysis should consider
the type of assets used, such as plant and equipment, valuable
intangibles, etc. and the nature of the assets used (i.e., the age,
market value, location, availability of intellectual property
protections), etc.
(v) An appraisal of risks is also important in determining arm’s
length prices/margins. The possible risks assumed that should
be considered in the functional analysis include market risks,
risks of change in cost, price or stock, risks relating to the
success or failure of R&D, financial risks such as changes in the
foreign exchange and interest rates, credit risks, etc.
(vi) In practice, one cannot be expected to compare all
functions, risks and assets employed. Hence, it must be
emphasized that only functions, risk and assets that are
economically significant in determining the value of
transactions or margins of entities should be identified and
compared.
(i) Prices may vary across different markets even for
transactions involving the same property or services. In order
to make meaningful comparisons of prices or margins between
entities/transactions, the markets and economic conditions in
which the entities operate or where the transactions are
undertaken should be comparable. the economic circumstances
that may be relevant in determining market comparability
include the availability of substitute goods or services,
geographic location, the market size, the extent of competition
in the markets, consumer purchasing power, the level of the
market at which the enterprises operate (i.e., wholesale or
retail), etc.
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(ii) Government policies and regulations (such as price controls,
national insurance, etc.) may have an impact on prices and
margins. Hence, the effects of these regulations should also be
examined as part of the examination for comparability of the
market and economic conditions.
(iii) Business strategies should also be examined in determining
comparability for transfer pricing purposes. Business strategies
would take into account many aspects of an enterprise, such as
innovation and new product development, degree of
diversification, risk aversion, assessment of political changes
and other factors bearing upon the daily conduct of business.
(iv) An entity may embark on business strategies of temporarily
charging a lower price for its product compared to similar
products in the market or incurring higher expenses in the short
run (hence resulting in lower profit levels). Such strategies are
commonly used for market penetration and market share
expansion or defense. The key issue with respect to business
strategies that temporarily reduce profits in anticipation of
higher long-term profit is whether the adoption and outcome of
such strategies produce an arm’s length result. Hence, a claim
that such strategies have been adopted ought to be
demonstrated with evidence that that an independent party
would have been prepared to sacrifice profitability for a similar
period under similar economic circumstances and competitive
conditions, so that a higher long-term profit can be realized.
SECTION 7. IDENTIFICATION OF THE TESTED PARTY AND THE
APPROPRIATE TRANSFER PRICING METHOD. (Step 2)
a. Determination of the Tested Party
The tested party is the entity to which a transfer pricing method
can be most reliably applied to and from which the most reliable
comparables can be found. For an entity to become a tested party,
the Bureau requires sufficient and verifiable information on such
entity.
b. Selection and application of Transfer Pricing Methodologies
(TPM)
(1) The specific methods to be used in determining the arm’s length
price are discussed in Section 10 of these Regulations.
(2) The selection of a transfer pricing method is aimed at finding the
most appropriate method for a particular case. Accordingly, the
method that provides the most reliable measure of an arm‟s length
result shall be used. For this purpose, the selection process should
take into account the following:
(i) the respective strengths and weaknesses of each of the transfer
pricing methods;
(ii) the appropriateness of the method considered in view of the
nature of the controlled transaction, determined in particular
through a functional analysis;
(iii) the availability of reliable information (in particular on
uncontrolled comparables) in order to apply the selected method
and/or other methods; and
(iv) the degree of comparability between controlled and
uncontrolled transactions, including the reliability of
comparability adjustments that may be needed to eliminate
material differences between them.
(3) The Bureau does not have a specific preference for any one
method. Instead, the TPM that produce the most reliable results,
taking into account the quality of available data and the degree of
accuracy of adjustments, should be utilized.
(4) In exceptional circumstances where there may not be
comparable transactions or sufficient data to apply the above-
described methods the Bureau may use the following approaches to
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verify whether the controlled transactions comply with the arm’s
length principle:
(i) Extension of the transfer pricing methods. The comparable may
be with enterprises in another industry segment or group of
segments; and
(ii) Use of a combination or mixture of the transfer pricing
methods or other methods or approaches.
(5) In all cases, taxpayers should be able to explain why a specific
TPM is selected or used in recording controlled transactions through
proper documentation.
c. Selection of Profit Level Indicator (PLI)
(1) In applying the TPM, due consideration must given to the choice
of PLI which measures the relationship between profits and sales,
costs incurred or assets employed. The use of an appropriate PLI
ensures better accuracy in the determination of the arm’s length
price of a controlled transaction. PLI is presented in the form of a
generally recognized or utilized financial ratio. The selection of an
appropriate PLI depends on several factors, including:
(i) characterization of the business;
(ii) availability of comparable data; and
(iii) the extent to which the PLI is likely to produce a reliable
measure of arm’s length profit.
(2) Commonly used PLI include:
(i) Return on costs: cost plus margin and net cost plus margin.
(ii) Return on sales: gross margin and operating margin.
(iii) Return on capital employed: return on operating assets.
SECTION 8. DETERMINATION OF THE ARM’S LENGTH RESULTS.
(Step 3)
Once the appropriate transfer pricing method has been identified,
such is applied on the data of independent party transactions to
arrive at the arm’s length result.
In some cases, it will be possible to apply the arm’s length principle
to arrive at a single figure or specific ratio (e.g. price or margin) that
is the most reliable to establish whether the conditions of a
transaction are arm's length. However, it is generally difficult to
arrive at a specific ratio or range of deviation that may be
considered as arm’s length. More likely, the transfer pricing analysis
would lead to a range of ratios. Hence, the use of ranges to
determine an arm’s length range shall be applied, provided that the
comparables are reliable.
a. If the relevant condition of the controlled transaction (i.e. price or
margin) is within the arm’s length range, no adjustment should be
made. If the relevant condition of the controlled transaction (e.g.
price or margin) falls outside the arm’s length range asserted by the
Bureau, the taxpayer should present proof or substantiation that the
conditions of the controlled transaction satisfy the arm’s length
principle, and that the result falls within the arm’s length range (i.e.
that the arm’s length range is different from the one asserted by the
tax administration). If the taxpayer is unable to establish this fact,
the Bureau must determine the point within the arm’s length range
to which it will adjust the condition of the controlled transaction.
b. In determining this point, where the range comprises results of
relatively equal and high reliability, it could be argued that any
point in the range satisfies the arm’s length principle. Where
comparability defects remain, it may be appropriate to use
measures of central tendency to determine this point (for instance
the median, the mean or weighted averages, etc., depending on the
specific characteristics of the data set), in order to minimise the risk
 TAXATION LAW 2
of error due to unknown or unquantifiable remaining comparability
defects.
SECTION 10. ARM’S LENGTH PRICING METHODOLOGIES. –
In determining the arm’s length result, the most appropriate of the
following methods may be used.
a. Comparable Uncontrolled Price (CUP) Method –
The CUP Method evaluates whether the amount charged in a
controlled transaction is at arm’s length by reference to the amount
charged in a comparable uncontrolled transaction in comparable
circumstances. Any difference between the two prices may indicate
that the conditions of the commercial and financial relations of the
associated enterprises are not arm’s length, and that the price in the
uncontrolled transaction may need to be substituted for the price in
the controlled transaction.
The use of the CUP Method to determine transfer price entails
identification of all the differences between the product or service
of the associated enterprise and that of the independent party. If
these differences have a material effect on the price, adjustment of
the price of products sold/services rendered by the independent
party to reflect these differences shall be made to arrive at the arm’s
length price. A comparability analysis under the CUP Method shall
take into account the following:
(1) Product characteristics such as physical features and quality;
(2) If the product is in the form of services, the nature and extent of
such services provided;
(3) Whether the goods sold are compared at the same points in the
supply or production chain;
(4) Product differentiation in the form of patented features such as
trademarks, design, etc.;
(5) Volume of sales if it has an effect on price;
(6) Timing of sale if it is affected by seasonal fluctuations or other
changes in market conditions;
(7) Whether cost of transport, packaging, marketing, advertising,
and warranty are included in the deal;
(8) Whether the products are sold in places where the economic
conditions are the same; and
(9) Whether a business strategy is adopted in the controlled
transaction that would produce material difference on the price of
the controlled transaction as against the price in an uncontrolled
transaction.
b. Resale Price Method (RPM) –
RPM is applied where a product that has been purchased from a
related party is resold to an independent party. Essentially, it seeks
to value the functions performed by the reseller of a product. The
resale price method evaluates whether the amount charged in a
controlled transaction is at arm’s length by reference to the gross
profit margin realized in comparable uncontrolled transactions.
This method is generally appropriate where the final transaction is
made with an independent party. The usefulness of the method
largely depends on how much added value or alteration the reseller
has done on the product before it is resold, or the time lapse
between purchase and onward sale. Thus, RPM is most appropriate
in a situation where the reseller adds relatively little value to the
properties. The greater the value added to the properties by the
reseller, for example, through complicated processing or assembly
with other products or, the longer the time lapse – to the extent that
market conditions might have changed – before it is resold or, when
the reseller contributes substantially to the creation or maintenance
of an intangible property that is attached to the product, such as
trademarks or trade names, the more difficult it is to use RPM to
arrive at the arm’s length price.
The starting point in RPM is the price (the resale price) at which a
product that has been purchased in a controlled sale is then resold
to an independent third party (uncontrolled resale). This price (the
resale price) is then reduced by an appropriate gross margin (the
resale price margin) representing the amount out of which the
 TAXATION LAW 2
reseller would seek to cover its selling and other operating
expenses and, in the light of functions performed (taking into
account assets used and risks assumed), make an appropriate profit.
An arm’s length price for the original transfer of property between
the associated enterprises (controlled transaction) is obtained after
subtracting the gross margin (resale price margin) from the resale
price, and adjusting for other costs associated with the purchase of
the product, such as customs duties.
The following are factors which may influence the resale price
margin and other considerations when performing a comparability
analysis for purposes of the resale price method:
(1) Functions or level of activities performed by the reseller and the
risks undertaken (e.g., whether the reseller is merely a forwarding
agent or, a distributor who assumes full responsibility for marketing
and advertising the product by risking its own resources in these
activities);
(2) Whether similar assets are employed in the controlled and
uncontrolled transactions, (e.g., a developed distribution network);
(3) Although broader product differences are allowed as compared
to the CUP method, product similarities are still significant to some
extent particularly when there is a high value or unique intangible
attached to the product;
(4) If the resale price margin used is that of an independent
enterprise in a comparable transaction, differences in the way
business is managed may have an impact on profitability;
(5) The time lapse between original purchase and resale of the
product as a longer time lapse may give rise to changes in the
market, exchange rates, costs, etc.;
(6) Whether the reseller is given exclusive rights to resell the
products;
(7) Differences in accounting practices where adjustments must be
made to ensure that the components of costs in arriving at gross
margins in the controlled and uncontrolled transactions are the
same;
(8) Whether cost of transport, packaging, marketing, advertising,
and warranty are included in the deal;
(9) Whether the products are sold in places where the economic
conditions are the same; and
(10) Whether a business strategy is adopted in the controlled
transaction that would produce material difference on the resale
gross margin of the controlled transaction as against the resale
gross margin in an uncontrolled transaction.
As gross profit margins represent the gross compensation (after
cost of sales) for specific functions performed, assets used and risks
assumed, product differences are less critical than under the CUP
Method. Therefore, where the related and independent party
transactions are comparable in all aspects except for the product
itself, RPM might produce a more reliable measure of arm’s length
conditions than the CUP Method. Nonetheless, it can be expected
that the more comparable the products, the more likely it is that the
RPM will produce better results.
c. Cost Plus Method (CPM) –
CPM focuses on the gross mark-up obtained by a supplier who
transfers property or provides services to a related purchaser.
Essentially, the method attempts to value the functions performed
by the supplier of the property or services. CPM is most useful
where semi-finished goods are sold between associated enterprises
or where the controlled transaction involves the provision of
services.
CPM indirectly measures whether the price for the property or
service in the controlled transaction is an arm’s length price by
assessing whether the mark-up on the costs incurred by the
supplier of the property or service in the controlled transaction
meets the arm’s length standard. This method is often useful in
cases involving the manufacture, assembly, or other production of
goods that are sold to related parties or where controlled
transaction involves the provision of intra-group services.
 TAXATION LAW 2
The starting point in CPM is the cost incurred by the supplier of
property or services in a controlled transaction for property
transferred or services provided to a related purchaser. An
appropriate mark-up is added to this cost to find the price that the
supplier should be charging the buyer.
The cost base used in determining costs and the accounting policies
should be consistent and comparable between the controlled and
uncontrolled transaction, and over time in relation to the particular
enterprise. The costs referred to in CPM are the aggregation of
direct and indirect costs of production.
Comparability, when applying CPM, should take into account the
similarity of functions performed, assets used and risks assumed,
contractual terms, market conditions and business strategies as well
as any adjustments made to account for the effects of any
differences in the aforementioned factors between the controlled
and uncontrolled transactions.
A comparability analysis under CPM shall take into account the
following:
(1) Functions or level of activities performed by the seller and the
risks undertaken;
(2) Whether similar assets are employed in the controlled and
uncontrolled transactions;
(3) Although broader product differences are allowed as compared
to the CUP method, product similarities are still significant to some
extent;
(4) If the gross margin used is that of an independent enterprise in a
comparable transaction, differences in the way business is managed
may have an impact on profitability;
(5) Differences in accounting practices where adjustments must be
made to ensure that the components of costs in arriving at gross
margins in the controlled and uncontrolled transactions are the
same;
(6) Whether cost of transport, packaging, marketing, advertising,
and warranty are included in the deal;
(7) Whether the products are sold in places where the economic
conditions are the same; and
(8) Whether a business strategy is adopted in the controlled
transaction that would produce material difference on the cost plus
mark-up of the controlled transaction as against the cost plus mark-
up in an uncontrolled transaction.
As in RPM, fewer adjustments may be necessary to account for
product differences under CPM than the CUP Method, and it may be
appropriate to focus on other factors of comparability (such as the
functions performed and economic circumstances). Where the
associated enterprise and independent party transactions are not
comparable in all aspects and the differences have a material effect
on the margin, taxpayers are expected to make appropriate
adjustments to eliminate the effects of these differences.
d. Profit Split Method (PSM).
PSM seeks to eliminate the effect on profits of special conditions
made or imposed in a controlled transaction (or in controlled
transactions that are appropriate to aggregate) by determining the
division of profits (or losses) that independent enterprises would
have expected to realize from engaging in the transaction or
transactions.
This method provides an alternative in cases where no comparable
transactions between independent parties can be identified. This is
true normally in a situation where transactions are very
interrelated that they cannot be evaluated separately, or in
situations involving a unique intangible. The method is based on the
concept that profits earned in a controlled transaction should be
equitably allocated among associated enterprises involved in the
transaction(s) on an economically valid basis that approximates the
allocation of profits that would have been anticipated and reflected
in an agreement made at arm’s length.
 TAXATION LAW 2
Generally, the profit to be split is the operating profit, but it may be
appropriate to carry out a split of the gross profit and then deduct
the expenses incurred by or attributable to each relevant party. The
allocation of profit or loss under the profit split method shall be
made in accordance with the following approaches:
(1) Residual Profit Split Approach. – The combined profits from
the controlled transactions under examination are split in two
stages.
(i) In the first stage, each participant is allocated sufficient profit
to provide it with a basic return appropriate for the type of
transactions in which it is engaged. Ordinarily, this basic return
would be determined by reference to the market return
achieved for similar types of transactions by independent
parties. Thus, the basic return would generally account for the
value, with reference to comparable independent market data,
of the contribution or functions performed by each party and
not account for the return that would be generated by any
unique and valuable assets possessed by the participants.
(ii) In the second stage, any residual profit (or loss) remaining
after the first stage division would be allocated among the
parties based on an analysis of the facts and circumstances that
might indicate how this residual would have been divided
between independent parties (i.e. taking into consideration the
value of unique assets used by the parties, usually intangible
assets). The remaining profit which is attributable to such
unique assets is allocated between the parties based on the
relative contributions of the parties to the creation of such
assets, taking into consideration how independent parties
would have divided such residual profits in similar
circumstances.
(2) Contribution Profit Split Approach. – The combined profits,
which are the total profits from the controlled transactions under
examination, are divided between the associated enterprises in a
single stage based upon the parties‟ relative contribution to the
profit or the relative value of the functions performed by each of the
associated enterprises participating in the controlled transactions,
supplemented as much as possible by external market data that
indicate how independent enterprises would have divided profits in
similar circumstances.
e. Transactional Net Margin Method (TNMM) –
TNMM operates in a manner similar to the cost plus and resale price
methods in the sense that it uses the margin approach. This method
examines the net profit margin relative to an appropriate base such
as costs, sales or assets attained by the member of a group of
controlled taxpayers from a controlled transaction.
TNMM compares the net profit margins attained by an entity from a
related party transaction to those attained by the same entity in
uncontrolled transactions or, by comparable independent entities
involved in similar transactions, relative to some appropriate base
such as costs, sales, or assets.
In short, TNMM evaluates whether the amount charged in a
controlled transaction is arm’s length by reference to the operating
profit earned in comparable uncontrolled transactions.
Being a transactional profit method that is typically applied to only
one of the parties involved in the transaction, the TNMM is closely
aligned to the resale price and cost plus methods.
This similarity means that this method requires a level of
comparability similar to that required for the application of the two
traditional transaction methods (the resale price method, and the
cost plus method).
The primary difference between TNMM and RPM or CPM is that the
former focuses on the net margin instead of the gross margin of a
 TAXATION LAW 2

transaction. However, one of the weaknesses of using net margin as

the basis for comparison is that it can be influenced by many factors
that either do not have an effect, or have a less substantial or direct
effect, on price or gross margins. Examples of such factors include
the efficiency of plant and machinery used, management and
personnel capabilities, competitive position, etc. Unless reliable and
accurate adjustments can be made to account for these differences,
TNMM may not produce reliable measures of the arm’s length net
margins.

TNMM is usually appropriate to use when the gross profit of the

business is not easy to determine such that either CPM, in case of a
manufacturer/service-provider, or RPM, in case of a distributor,
cannot be used. Since the net margin figure is always available,
TNMM may be used instead, applying the same formula as those for
CPM (for manufacturer/service provider) or RPM (for distributor)
but rather using net margin in lieu of the gross margin/profit.

RMO NO. 1-2019 (See PDF - di ko alam kung tama to kasi parang di
naman related)